Valuation-Informed Indexing #30 Rebalancing Hurts As Often As It Helps

The premise of the Buy-and-Hold Model is that price changes cannot be predicted because they are determined by unforeseeable economic developments. If this is so, stocks are an equally appealing asset class at all times and stock investors should at all times stick with the stock allocation that is right for someone in their financial circumstances and possessing their tolerance for risk.

Price jumps and drops cause the investor’s stock allocation to get out of whack. So Buy-and-Holders practice occasional rebalancing (selling stocks following price jumps, buying stocks after price drops) with the aim of keeping their stock allocations constant.

Valuation-Informed Indexers believe that long-term price changes can be predicted because investor emotion is the primary influence on stock prices in the short term and the economic realities are the primary influence in the long term. Stock prices are always being pulled in the direction in which they must go to close the gap between the current price and the fair-value price. Thus, investors must change their allocations in response to big price swings to keep their risk profiles roughly constant.

Risk is a constant under the Buy-and-Hold Model. Risk varies with price changes under the Valuation-Informed Indexing Model.

Rebalancing thus has a different effect under the two models.

For a Valuation-Informed Indexer, rebalancing is a good thing but not a necessary thing. It is a good thing because rebalancing permits the investor to get back to the stock allocation he intends to be at while valuations are within a specified range.

However, it is not a necessary thing because the Valuation-Informed Indexer changes his allocation when it gets too out of whack in any event. Rebalancing serves as a way of fine-tuning one’s stock allocation, under this model.

Rebalancing can be either a plus or a minus for Buy-and-Holders, from the perspective of the Valuation-Informed Indexer.

Say that a Buy-and-Holder began investing in the time-period from 1996 through 2008, during which stock prices remained at insanely high levels for 13 years. Say that he determined that a 70 percent stock allocation was right for someone in his financial circumstances and with his risk tolerance. According to the Valuation-Informed Indexing Model, the proper stock allocation for this investor might have been 20 percent. So the investor’s stock allocation was dangerously high.

A price jump of 20 percent would have caused the investor’s stock allocation to go higher still. Rebalancing would have brought it back to 70 percent stocks. Rebalancing in this case would have pulled the allocation a bit in the right direction. So it would have been a plus.

But what if prices fell 20 percent instead? In that event, rebalancing would have required the investor to buy stocks and thereby to pull his stock allocation back up to the dangerous 70 percent level. In this case rebalancing would have been a negative.

The Buy-and-Hold Investor is investing blind (presuming that the Valuation-Informed Indexers are right in believing that valuations affect long-term returns). If valuations affect long-term returns, it is not possible to set one’s allocation properly without taking valuations into consideration. Buy-and-Holders do not do this. So they have no way of knowing what their stock allocations should be.

Rebalancing is a dubious endeavor for the Buy-and-Holder. It is an effort to return to a stock allocation that may be too high, too low, or about right. For rebalancing to work, you need to be employing it to return to the stock allocation that is right for you. If valuations really do affect long-term returns, it is not possible to identify this allocation without taking valuations into account.